By Michael McCarthy

Volatility falling, markets calming, several days of cautious gains. While investors remain nervous, there is more confidence that the end of the (economic) world is averted once more. The longer the Australian share market respects the late August low point, the more investors will wade into the market. The question remains; where to invest?

Where to invest?

The answer to the question is different for every investor. The reason is the “right” investment is a function of personal factors, as well as externals like company valuation, market conditions and economic outlook.  Income, time horizon and risk appetite all come into play in the investment selection process. Perhaps the most important aspect is considering new investments in light of the existing portfolio.

Many investors have faced this issue over the last three years. Dividend yields drove investment decisions in a large number of portfolios in this period, as income gave investor comfort. However, the same handful of stocks kept re-appearing at the top of the recommended list. Investors who acted on this alone found themselves in very narrow portfolios, with large amounts invested in relatively few stocks. This lack of diversification meant heightened risk.

International influence

Weaker job numbers last week put paid to US interest rate rises – for now. The other major driver of the sell off is on holiday at the moment. China is celebrating golden week. Next week, China will release retail sales, industrial production, inflation and GDP growth data. At recent lows, markets were pricing a collapsed in China. If next week’s data shows anything less than a collapse, it is likely a positive for shares, albeit with much mean-spirited grumbling about data quality.

If both of the major worries are off the boil, and share markets are set to rise, what sectors are best placed? Some will turn to the sectors most deeply affected, meaning commodity exposed stocks such as energy and materials.

There is an argument that these sectors are double pricing the risks, with share prices reflecting not only the massive falls in oil and metals prices so far, but further commodity price falls to come. This does not hold up if we respect the idea that commodity markets are already reflecting the balance of price probabilities.

The process

Investors looking at the energy sector may list all members of the sector, and possibly work through an investment process.

Choose blue chips – after a market selloff, there is no need to be too clever. All shares come off, whether high or low quality. This often means there is little or no premium for quality. Given the choice, why not take quality? The list is narrowed to energy stocks in the top ASX200 index.

Product focus – the lower carbon emissions of gas make it an obvious choice for the long term. Pure oil, coal and uranium miners are removed from the list. Retail and wholesale distribution is an important sector of the industry, but tends more towards utility earnings, and is not the exposure sought.

Distribution networks are removed from the list.

Where are they in price terms?

Remember all those sober and serious voices that warned against “catching a falling knife”. One certainty is that they didn’t buy any Woodside or Oil Search at what may turn out to be generational lows. The rally in these two high quality exposures, after Woodside’s takeover bid for Oil Search, may mean those ships have sailed.

Nonetheless, the remaining stocks offer both short term and long term opportunities. A period of significant catch up is on the cards. In my view, Santos’ strategic failures take it out of consideration. Beach’s deep discount may attract attention, and like Santos is looking for a new CEO. The appointment of a respected operator could be a catalyst in either case.

Yesterday’s announcement from AWE of strong gas flows in test drilling at its WA green field site may push it in front of investors. Karoon’s WA gas fields have currency kickers from their operations in Peru and Brazil. And LNG has oil and gas operations with an industrial technology exposure through its gas compression process. The choice is up to the investor, but the imperative to act is coming from the market.